Regulatory changes are forcing Australian banks to step away from the private debt market, giving institutional investors an opportunity to “take over where the banks formerly were”, said Bob Sahota, managing director and chief investment officer of newly launched private debt fund Revolution Asset Management.
Private debt as an asset class is well entrenched overseas but it is not popular in Australia among institutional investors, despite being about $2.8 trillion in size – larger than the Australian superannuation pool – Sahota told the Investment Magazine Fixed Income and Credit Forum, held in Victoria in late July.
“The Australian private debt market is basically a column of ticks,” Sahota said, during a session titled “The return spectrum of private debt strategies”. “It’s like you’re in the US and Europe and…going back [in time] 15 years in terms of those markets. So that makes it a really, really compelling asset class.”
Sahota was formerly head of fixed income at ASX-listed investment management firm Challenger, and has more than 25 years of experience in private debt.
The popularity of private debt has led to some “really unwelcome changes” overseas, particularly the increasing prevalence of “covenant-lite” loans, Sahota said. While these peaked at 30 per cent of newly issued loans about the time of the financial crisis, that figure has now crossed 80 per cent in Europe, he said.
Covenant-lite loans were previously extended only to the best and brightest companies with very stable cash flows, but they are now being given to weaker entities, including potential “zombie companies” that will fold if interest rates rise, he told the conference.
“This is quite an alarming trend, and what we see, going forward, is that when the default cycle comes – and it’s a matter of when, not if – we expect the recovery rates in the next cycle will be far lower than what we’ve seen in previous cycles, as a result of this.”
Covenant-lite aside, private debt has a range of advantages over other investments, Sahota said. It is offered on a floating rate so it acts as an inflation hedge. It is secured and protected by covenants, allowing the lender to enforce its security in the event of underperformance. It also delivers access to information on the performance of the companies and transactions involved, allowing a monthly or quarterly “litmus test” that enables the lender to step in early if things aren’t shaping up.
Further, it provides a stable income stream that is contracted for the life of the instrument and offers diversification outside of the concentration in banking and finance that is found in the corporate bond market.
It also shows low or negative correlation with other, more established, parts of fixed income portfolios, he said. A study by Revolution modelled a private debt investment over 10 years and found it had a minus 0.26 correlation with the ASX 200 and a low 0.34 correlation with the AusBond composite bonds index. This low correlation also applied to overseas markets, Sahota said.
The appeal of private debt has led it to garner a participation rate for non-bank institutional lenders of about 90 per cent overseas.
“So it really is an institution-led market [in the US], unlike in Australia,” Sahota said. “Australia is completely the opposite. A few new funds, including ours, have set up, and we would say it’s 90 per cent bank-led in this market, and 10 per cent institutions.”